By Tommy Stubbington
The U.K. economy is picking up, but the country's stock market
isn't.
Amid all of Europe's struggles in 2014, the region's
worst-performing major market index is London's flagship FTSE 100,
which has fallen 3%. Even Italy, whose economy is set to contract
in 2014 for the third year running, has mustered a small gain.
And investors in the U.K. see few reasons for optimism in 2015.
The FTSE is filled with oil producers, miners and others slumping
in the commodities rout. The Bank of England looks set to tighten
monetary policy. And an unpredictable general election looms in the
spring.
Britain's underperformance is notable given its relative
strength: Its economy is expected to grow faster this year than any
of the 18 eurozone countries except Ireland, according to the
European Commission's most recent forecast. Yet the FTSE's 3%
decline compares with a 4% gain in the pan-European Stoxx Europe
600 excluding U.K. shares. The comparison with the U.S. is even
less flattering: The S&P 500 is up 13% this year as of Tuesday
afternoon. Even Russia, gripped by punishing sanctions and a
financial crisis, is faring only somewhat worse. The Micex index,
which is priced in rubles, is down 7%. (In dollar terms, Russian
markets have fallen spectacularly alongside the plummeting
ruble.)
Energy companies--a hefty presence on London markets--have found
themselves in the firing line following a collapse in oil prices
since the summer. Tullow Oil PLC and BG Group PLC are among the
worst performers on the FTSE, while giant BP PLC has also stumbled.
That is likely to continue to weigh on the market as the effect of
cheaper oil feeds through to company profits, investors say.
"Earnings in the energy sector had shown signs of stabilization
in recent months, but the decline in oil prices in the second half
of this year means earnings are likely to take a leg down," said
Mark Haefele, global chief investment officer at UBS Wealth
Management, which oversees around $2 trillion of assets.
But there have also been pockets of weakness in sectors that
would typically benefit from an economic recovery, such as food
retail. Grocery chains Tesco PLC, J Sainsbury PLC and Wm. Morrison
Supermarkets PLC have all fallen by 30% or more. An accounting
scandal at Tesco has been compounded by a price war as cost-cutting
rivals nab market share from the established chains and low
inflation hampers retailers' ability to raise prices.
"Increased competition in the food retail sector is a good thing
for growth but bad from shareholders' perspective. That doesn't
look like it's about to change," said Guy Foster, head of portfolio
strategy at wealth manager Brewin Dolphin, which oversees GBP29.4
billion ($45.6 billion) of assets.
Brewin Dolphin favors U.S., eurozone and Japanese markets over
U.K. stocks in its portfolios, Mr. Foster said, even though the
latter look relatively cheap.
The FTSE 100 currently trades on a forward price-to-earnings
ratio--a measure of how much investors are prepared to pay for each
pound of expected profit next year--of 13.89, according to FactSet.
That compares with 16.13 for the Stoxx Europe 600 excluding the
U.K.
Many other investors are similarly downbeat.
A survey of more than 100 money managers carried out this month
by Bank of America Merrill Lynch showed that a net 16% are
underweight U.K. stocks. "The U.K. remains the least favored region
globally," the bank said.
Mr. Haefele at UBS Wealth also worries that a thriving economy
could actually hurt shares. The British economy expanded at a rate
of 2.6% in the three months to September, compared with a year
earlier, while the eurozone barely eked out any growth at all. For
much of 2014, the strengthening economy prompted bets that the Bank
of England would raise interest rates in the coming year. Those
expectations have been pushed back recently amid a slowing of the
pace of inflation across the globe, but investors still think the
BOE will be one of the first major central banks to increase rates.
Such a move would boost the U.K. pound--bad news for the FTSE 100's
exporters and multinationals, which earn more than 75% of their
revenue overseas.
The prospect of stronger sterling against the euro is one reason
why UBS Wealth this month further cut its holdings of U.K. stocks,
having already been underweight, Mr. Haefele said.
This dim view reverses the situation of the previous few years,
when shares remained buoyant despite a struggling economy. During
the financial crisis, ultraloose BOE policy weakened sterling and
drew investors to the relative safe haven of U.K. government debt.
Lower bond yields meant equity markets looked more attractive by
comparison.
"People used to ask why the stock market is doing so well when
we're having a triple-dip recession. Now the question has been
turned on its head," said Mr. Foster of Brewin Dolphin.
An unpredictable general election in May also presents a
challenge for investors. Current polls indicate that traditional
major parties will struggle to cement an overall majority,
increasing the likelihood of a place in government for the
separatistScottish Nationalist Party, or the United Kingdom
Independence Party, which advocates a British departure from the
European Union.
That is a prospect that markets are currently ignoring, but are
likely to react to next year, said Frederic Dodard, head of
investment solutions at State Street Global Advisors, which manages
$2.38 trillion. State Street prefers U.S. stocks to European, with
political uncertainty in the U.K. and the eurozone partly
responsible for the caution, according to Mr. Dodard.
"A higher level of uncertainty is never good for risk assets,"
he said.
Write to Tommy Stubbington at tommy.stubbington@wsj.com
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